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Oil – the big drop

By Mark Rule, Equity Analyst

If we page back in history, it is evident that the price of oil tends to undergo a significant correction approximately every four years. It is not so much these historic occurrences that are of interest, but the behaviour of the oil market during these price fluctuations.

Historically, it appears that market action drives the oil price lower than the marginal cost of production. This forces some supply curtailment and allows the price to recover. In the last five major corrections, the price declined on average by 48%, but subsequently recovered by an average increase of 95%!

The chart below shows the ICE Brent oil price with the corrections highlighted in green. The primary driver of the recovery in prices has been OPEC production cuts, led by Saudi Arabia. This was particularly relevant in recent history, between 2011 and 2013, when Saudi Arabia adjusted its production to compensate for Libyan production fluctuations, thus supporting the crude oil price. This historic response changed recently when Saudi Arabian influence led an OPEC decision to maintain production despite the drop in crude oil prices. The Saudi Arabians and their Middle Eastern OPEC counterparts have stood firmly in favour of this decision, in the face of a strong increase in non-OPEC oil production.

Saudi Arabia was previously the global swing producer and was capable of controlling prices by adjusting production, supported by the cooperation of its fellow OPEC producers. Through the mechanism of raising or lowering production, something OPEC did with enough cooperative compliance to make a difference to global benchmark prices, OPEC was able to keep oil prices stable. Incidentally, this strategy effectively supported the Saudi Arabian domestic budget funding requirements and those of a number of its lower-cost producing counterparts.

In spite of the buoyant prices, some higher-cost producing members have been ‘underwater’ for several years. However, while OPEC stabilised the oil price by ‘opening and closing its output valves’, the resultant high level of oil prices provided an incentive for the US onshore shale gas industry to develop. The hydraulic fracturing (fracking) technology now in use has been refined in recent years and has been deployed widely in the US in light of the high return on investment available until recently. Tongue-in-cheek, one could regard this as OPEC’s blind spot, which has suddenly crept into reality, forcing OPEC to react.

To their credit, the major OPEC members started to tell markets late last year that they should get used to lower oil prices and that OPEC was no longer going to manipulate pricing by adjusting volumes. OPEC remained true to this strategy when it tabled a decision to maintain output at 30 million daily barrels, at the scheduled OPEC meeting in November 2014. It should be emphasised that this change in strategy amounted to a paradigm shift in the way OPEC thinks about global oil markets. OPEC’s decision to allow prices to find a much lower equilibrium level is equivalent to laying down the gauntlet to US onshore shale oil producers. These producers’ production costs, in US dollars, range from a low end in the mid-thirties to highest costs in the mid-seventies.

At oil prices of above US$90 per barrel, the decision to invest in shale oil extraction by US investors was easy. Not so, with the current West Texas Intermediate (WTI) oil price at a US dollar price in the mid-forties. We can be reasonably certain that some of the US shale oil production will be reduced in coming months at the current low price and the incentive to deploy capital for expansion is unlikely to result in new projects in the near future. An indication of the impact of such investment decision-making is given in the chart below, which shows a decline in the oil rig count in the Bakken region of North Dakota and for the US as a whole.

Additionally, non-OPEC oil supply has been rising for some time, adding significant new supply capacity to the global market. It is apparent from US statistics that per capita oil consumption has been declining for almost a decade, due to a tendency to drive fewer kilometres in increasingly fuel-efficient vehicles, by an aging population. These two factors may be marginal, but are both likely to continue to place pressure on oil prices in future. An offsetting trend on the demand side is the low consumption in emerging markets, and the growth in vehicle ownership in these countries.

Many questions are raised given the dynamics that have led to the new reality in oil markets. Not least the potential for petrol prices to decline. The global oil supply picture changed structurally with the introduction of a relatively low cost source of new production (US shale oil). This growing source of non-conventional oil has not only increased global oil supply, but has also lowered the marginal cost of oil production and therefore lowered price support for oil. This source of oil has added well over two million barrels of oil per day into global markets (c.2% of global supply). Because regulations largely disallow export of crude oil from the US, the additional shale oil production has directly resulted in lower imports by the US. Bear in mind that total global oil production is around 93 million barrels per day and this growing source has and will continue to have market consequences.

With this significant addition of production capacity in the world market, which is relatively easy to start up and shut off, two developments have emerged. Firstly, lower oil prices in the short to medium term and secondly, a longer-term oil price that is capped by the marginal US shale oil producer’s production costs. Therefore the oil price recovery this time round is expected to be muted relative to the historic rebounds mentioned above.

For South African consumers the fuel price reductions are welcome and are likely to hold fuel prices structurally lower for some time, allowing an uptick in discretionary spend in other consumer goods and services.